KeyBank 2005 Annual Report Download - page 29

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
The following discussion explains the composition of certain components
of Key’s noninterest expense and the factors that caused those components
to change.
Personnel. As shown in Figure 12, personnel expense, the largest category
of Key’s noninterest expense, rose by $57 million, or 4%, in 2005 and $56
million, or 4%, in 2004. The 2005 increase resulted from growth in all
personnel expense components, due in part to the impact of normal salary
increases, increased business activity, and expansion through acquisitions
such as AEBF in December 2004. In 2004, the increase resulted from higher
incentive compensation accruals and an increase in stock-based
compensation expense. Most of Key’s stock options are granted in July and
have a three-year vesting period. Each year since the 2003 adoption of the
fair value method of accounting for stock options under SFAS No. 123,
stock option expense recognized by Key has grown as new options granted
in July begin to vest with other post-2002 grants. This expense growth is
illustrated in Note 1 (“Summary of Significant Accounting Policies”)
under the heading “Stock-Based Compensation” on page 61.
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Year ended December 31, Change 2005 vs 2004
dollars in millions 2005 2004 2003 Amount Percent
Salaries $ 878 $ 848 $ 858 $30 3.5%
Incentive compensation 396 393 338 3 .8
Employee benefits 263 258 255 5 1.9
Stock-based compensation
a
54 40 23 14 35.0
Severance 15 10 19 5 50.0
Total personnel expense $1,606 $1,549 $1,493 $57 3.7%
a
Excludes directors’ stock-based compensation of $2 million in 2005, $1 million in 2004 and $1 million in 2003 reported as “miscellaneous expense” in Figure 11.
FIGURE 12. PERSONNEL EXPENSE
One of management’s top four priorities has been to maintain a
disciplined approach to managing expenses. We will continue to evaluate
staffing levels and make cost-saving changes when they can be
accomplished without damaging either client service or our ability to
develop higher-return businesses. For 2005, the average number of
full-time equivalent employees was 19,485, compared with 19,576 for
2004 and 20,064 for 2003. The average number of Key’s full-time
equivalent employees has declined for seven consecutive years.
Net occupancy. During the first quarter of 2005, the Securities and
Exchange Commission (“SEC”) issued interpretive guidance, applicable
to all publicly held companies, related to the accounting for operating
leases. As a result of this guidance, Key recorded a net occupancy
charge of $30 million to adjust the accounting for rental expense
associated with such leases from an escalating to a straight-line basis.
This adjustment accounted for almost 70% of the $44 million, or
19%, increase in net occupancy expense in 2005.
Professional fees. In 2005, the $16 million, or 14%, increase in
professional fees was due in part to higher costs associated with Key’s
efforts to strengthen its compliance controls.
Franchise and business taxes. Franchise and business taxes rose by $18
million in 2005, in part because the 2004 amount was unusually low. In
the first quarter of 2004, we recorded a $7 million adjustment to
reverse certain business taxes that had been overaccrued. In 2004, the
$29 million, or 64%, decrease also included a $9 million reclassification
of expense to “income taxes” in the fourth quarter.
Miscellaneous expense. In 2005, the $26 million, or 7%, growth in
“miscellaneous expense” included a $15 million increase in loan
servicing expense. In addition, miscellaneous expense for 2005 included
contributions of $35 million to our charitable trust, the Key Foundation,
and a $16 million reserve established in connection with Key’s education
lending business. This reserve was established to absorb noncredit-
related losses expected to result from Key’s decision to discontinue the
funding of new student loans for certain schools. The amount of the
reserve was based on Key’s evaluation of the likelihood that the schools
will close, and the dollar amount of unfunded loan commitments to
students of those schools through the end of 2005. At December 31,
2005, the balance remaining in the reserve was $14 million.
The previously mentioned $55 million write-off of goodwill recorded
during the fourth quarter of 2004 in connection with management’s
decision to sell Key’s nonprime indirect automobile loan business
substantially offset the overall increase in “miscellaneous expense” for
2005 and was the primary driver of the increase in 2004.
Income taxes
The provision for income taxes was $459 million for 2005, compared
with $434 million for 2004 and $339 million for 2003. The effective tax
rate, which is the provision for income taxes as a percentage of income
before income taxes, was 28.9% for 2005, compared with 31.3% for
2004 and 27.3% for 2003.
The higher effective tax rate for 2004 was due primarily to the $55
million nondeductible write-off of goodwill discussed above, and a
$43 million reduction in deferred tax assets that resulted from a
comprehensive analysis of Key’s deferred tax accounts. Excluding these
charges, the effective tax rate for 2004 was 27.6%.
The effective tax rates for the past three years (excluding the charges
mentioned above) are substantially below Key’s combined federal and
state tax rate of 37.5%, due primarily to income from investments in tax-
advantaged assets such as corporate-owned life insurance, credits associated
with investments in low-income housing projects and tax deductions
associated with dividends paid on Key common shares held in Key’s 401(k)
savings plan. In addition, a lower tax rate is applied to portions of the
equipment lease portfolio that are managed by a foreign subsidiary in a lower
tax jurisdiction. Since Key intends to permanently reinvest the earnings of this
foreign subsidiary overseas, no deferred income taxes are recorded on those
earnings in accordance with SFAS No. 109, “Accounting for Income Taxes.”